common people for the common good

common people for the common good

Yesterday, I listened to a very interesting interview of James K. Galbraith by my favorite interviewer, George Kenney at electric politics. They cover a lot of ground, and there are lots of interesting ideas on the current economic crisis, but there was one piece of information I haven’t heard anywhere else that I thought might be of special interest. It has to do with how the Swedish government nationalized banks during their banking crisis in 1992. I’ve transcribed (rough) two small parts of the interview. The first is on one of the ways Galbraith considers the thinking behind attempts so far to deal with the crisis is just conceptually wrong (don’t just throw money at the banking industry – it won’t work and it will create incentives for bank officers to take destructive actions). The second is on the Swedish example of bank nationalization:

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James K. Galbraith: Banks don’t lend capital, banks create money by making loans. They don’t actually need money put into them in order to lend. That’s a misconception of how banks operate. Banks are not constrained in their lending activity, but they are influenced in their risk taking activity when they don’t have enough capital to meet their capital requirements when they are insolvent. They have a terrific incentive in that case to take inordinate risks, to take the most speculative risks available in an effort to recover solvency before the regulators come in and shut them down. So there’s every likelihood in this situation that banks if they did anything at all in a response to an initiative to do things, is that that they would put funds into the most volatile and speculative markets – basically into commodity markets where they would have some chance maybe fleeting maybe unsuccessful but some chance to recover capital, to recover solvency, before the fact that they are really not viable institutions at the moment becomes something that the regulators can’t continue to ignore.

George Kenney: So we put hundreds of billions of dollars into these walking dead banks, and they turn around and they try to pump up another asset bubble?

James K. Galbraith: Yes. Although, as I said, they don’t actually need the hundreds of billions of dollars in order to do this. They can do it simply if they have access to deposits which they may do simply because they’re insured. So that a bank, a bank which is insolvent, can still lend like crazy if you give it a guarantee on it’s deposits and don’t regulate it’s behavior. And that’s basically exactly what happened in the saving and loan crisis in the early 1980s. Because the regulators failed to come in and deal with the banks, take them over and control their behavior, they had an enormous incentive to engage in doubling down, in doubling their bets and trying to recover their capital. The other incentive that they had and which many of them acted on was to loot the institution because after all sooner of later the regulators are going to come in and you’re going to loose your access to all this wealth and power. So the top officers, if the institutions weren’t actually taken over by criminal networks, which happened in very important cases, Charles Keating and Don Dixon and others, the existing officers had an incentive at least to behave in ways to destroy the institution.

George Kenney: And we saw some of that in the early phases the bail out where some of these investment banks were still engaged in all kinds of derivatives trading, right?

James K. Galbraith: Yes, there’s that but there’s also the very simple fact that they continued to pay outsized bonuses to their top officers and big dividends to their common stock holders in spite of the fact they were getting federal funds. In fact one could argue that’s where the federal funds went.

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If what Paulson & Bernanke and now Geithner & Bernanke & Summers have done so far doesn’t make any sense, what should we be doing? Galbraith argues, as Dean Baker, Paul Krugman and some here have, for nationalization. Here’s Hugh:

A bank nationalization would allow the government to force banks to declare their insolvency and the value of their toxic assets at whatever value the government named. For me, the best assessment is the pre-bubble price. This would allow the government to recapitalize banks in a transparent way. It could use them to refinance mortgages at pre-bubble prices. It could get them to re-initiate normal lending practices eliminating the credit crunch, and it could break them up to prevent entities which are too monopolistic and too big to fail.

If we were to go this route we have the successful model of the Swedish banking rescue to guide us. From wikipedia:

During 1991 and 1992, a housing bubble in Sweden deflated, resulting in a severe credit crunch and widespread bank insolvency. The causes were similar to those of the subprime mortgage crisis of 2007-2008. In response, the government took the following actions:[1]

The government announced the state would guarantee all bank deposits and creditors of the nation’s 114 banks.

Sweden’s government assumed bad bank debts, but banks had to write down losses and issue an ownership interest (common stock) to the government. Shareholders were typically wiped out, but bondholders were protected.

Nordbanken and Götabanken were granted financial support and nationalized at a cost of 64 billion kronor.[2]

The firms’ bad debts were transferred to the asset-management companies Securum and Retriva which sold off the assets, mainly real estate, that the banks held as collateral for these debts.

When distressed assets were later sold, the proceeds flowed to the state, and the government was able to recoup more money later by selling its shares in the nationalized banks in public offerings.

Sweden formed the Bank Support Authority[3]. to supervise institutions that needed recapitalization.

This bailout initially cost about 4% of Sweden’s GDP, later lowered to between 0-2% of GDP depending on various assumptions due to the value of stock later sold when the nationalized banks were privatized.

But, according to Galbraith, there was more to it than that – there is a Swedish law that makes the banks’ directors allies of the regulators in implementing nationalization when a bank becomes insolvent:

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James K. Galbraith: The major institutions in the financial system, the major banks are clearly insolvent, they are clearly being kept out of the normal regulatory intervention which is to seize the banks and reorganize them by a willful act to refuse the recognize what is clearly the economic reality which is that the banks are deeply under water.

George Kenney: So, to do like Sweden did basically?

James K. Galbraith: Well yes. And to be clear, what Sweden… the Swedish case is very interesting. There is a provision in Swedish law, which holds that when a bank is insolvent, if it continues to incur losses, past the point of insolvency, those losses are the personal liability of the directors.

George Kenney: Uh, oooh.

James K. Galbraith: Oh, yeah. So, when a bank is insolvent in Sweden, the banks’s directors have a very strong incentive to find it out and come to a decision to go to the government and say, "The bank is yours. We are no longer in charge because we represent the shareholders and the shareholders don’t have any capital left." And that’s what happened in 1992. The government then has a free hand to reorganize the institution: change the management, isolate the bad assets, wipe out the capital at risk, insure the deposits, separate the bad assets from what remains of good assets and float off the good assets as a new bank.

George Kenney: And that worked, right?

James K. Galbraith: Of course, it worked very fast. But you can’t do it unless you start.

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Tuesday Geithner is scheduled to announce the new bank-rescue plan (aka. the Financial Stability and Recovery Plan). No indication yet (except in my dreams) that it might be something along the lines of the Swedish Model instead of more of the same failed policy we’ve seen from Paulson & Bernanke. But at some point we’re going to have to reorganize and reregulate our financial industry. Can we add this Swedish Banking Law to the TODO list?